1/ THE FUNDAMENTAL CONCEPT OF CASH FLOW FROM OPERATING ACTIVITIES

The cash flow statement (see Chapter 5) is designed to separate operating activities from investing and financing activities. Accordingly, it shows cash flows from operating and investing activities and investments on the one hand, and from financing activities on the other. This breakdown will be very useful to you when valuing the company and examining investment decisions.

The concept of cash flow from operating activities, as shown by the cash flow statement, is of the utmost importance. It depends on three fundamental parameters:

• the rate of growth in the company's business;
• the amount and nature of operating margins;
• the amount and nature of working capital.

An analysis of the cash flow statement is therefore the logical extension of the analysis of the company's margins and the changes in working capital.

Analysing the cash flow statement means analysing the profitability of the company from the point of view of its operating dynamics, rather than the value of its assets.

2/ FREE CASH FLOW AFTER INTEREST

Free cash flow after interest is equal to cash flows from operating activities minus cash flows from investments (capex net of disposal of fixed assets). It therefore includes the investment policy of the firm.

Free cash flow after interest measures, if negative, the financial resources that the company will have to find externally (from its shareholders or lenders) to meet the needs for cash generated by its operating and investment activities. If positive, the firm will be able to reduce its debt, to pay dividends without having to raise debt or even to accumulate cash for future needs. Free cash flow after interest will therefore set the tune for the financing policy.

3/ HOW IS THE COMPANY FINANCED?

As an analyst, you must understand how the company finances its activities over the period in question. New equity capital? New debt? Reinvesting cash flow from operating activities? Asset disposals can contribute additional financial resources.

You should focus on three items for this analysis: equity capital issues, debt policy and dividend policy.

• Financing through new equity issuance: did the firm call for new equity from its shareholders during the period and, if yes, what was it used for (to reduce debt, to finance a new capex programme)? You can also come across the opposite situation whereby the company buys back part of its shares; this, like dividends, is a way of returning cash to shareholders.¹ In this case, does the company want to alter its financial situation? Does it no longer have any investment opportunities?
• Financing through debt: analysing the net increase or decrease in the company's debt burden is a question of financial structure:
  • If the company is paying down debt, is it doing so in order to improve its financial structure? Has it run out of growth opportunities?
  • If the company is increasing its debt burden, is it taking advantage of unutilised debt capacity? Or is it financing a huge investment project or reducing its shareholders' equity and upsetting its financial equilibrium in the process?
• The dividend policy: as we will see in Chapter 37, the company's dividend policy is also an important aspect of its financial policy. It is a valuable piece of information when evaluating the company's strategy during periods of growth or recession:
  • Is the company's dividend policy consistent with its growth strategy?
  • Is the company's cash flow reinvestment policy in line with its capital expenditure programme?

You must compare the amount of dividends with the investments and cash flows from operating activities of the period.

In Section III of this book, we will examine the more complex reasoning processes that go into determining investment and financing strategies. For the moment, keep in mind that analysis of the financial statements alone can only result in elementary, common-sense rules.

As you will see later, we stand firmly against the following “principles”:

• The amount of capital expenditure must be limited to the cash flow from operating activities. No! After reading Section III you will understand that the company should continue to invest in new projects until their marginal profitability is equal to the required rate of return. If it invests less, it is underinvesting; if it invests more, it is overinvesting, even if it has the cash to do so.
• The company can achieve equilibrium by having the “cash cow” divisions finance the “glamour”² divisions. No! With the development of financial markets, every division whose profitability is commensurate with its risk must be able to finance itself. A “cash cow” division should pay the cash flow it generates over to its providers of capital, who are then free to reinvest those funds in other projects.

Studying the equilibrium between the company's various cash flows in order to set rules is tantamount to considering the company a world unto itself. This approach is diametrically opposed to financial theory. It goes without saying, however, that you must determine the investment cycle that the company's financing cycle can support. In particular, debt repayment ability remains paramount. We have already warned you about that in Chapter 2!

1/ CAN THE COMPANY REPAY ITS DEBTS?

The best way to answer this simple, fundamental question is to take the company's business plan and project future cash flow statements. These statements will show you whether the company generates enough cash flow from operating activities such that after financing its capital expenditure, it has enough left over to meet its debt repayment obligations without asking shareholders to reach into their pockets. If the company must indeed solicit additional equity capital, you must evaluate the market's appetite for such a capital increase. This will depend on who the current shareholders are. A company with a core shareholder will have an easier time than one whose shares are widely held, as this core shareholder, knowing the company well, may be in a position to underwrite the share issue. It will also depend on the value of equity capital (if it is near zero, maybe only a vulture fund³ will be interested).

Naturally, this assumes that you have access to the company's business plan, or that you can construct your own from scenarios of business growth, margins, changes in working capital and likely levels of capital expenditure. We will take a closer look at this approach in Chapter 31.

Analysts and lending banks have, in the meantime, adopted a “quick-and-dirty” way to appreciate the company's ability to repay its debt: the ratio of net debt to EBITDA. This is, in fact, the most often used financial covenant⁴ in debt contracts! This highly empirical measure is nonetheless considered useful, because EBITDA is very close to cash flow from operating activities, give or take changes in working capital, interest and income tax. A value of 3 is considered a critical level, below which the company should generally be able to meet its repayment obligations.

If we were to oversimplify, we would say that a value of 3 signifies that the debt could be repaid in 3 years provided the company halted all capital expenditure and didn't pay corporate income tax during that period. Of course, no one would ask the company to pay off all its debt in the span of 3 years, but the idea is that it could if it had to.

Conversely, a firm with debt representing 5 times EBITDA would have to stop any investment for 5 years to meet its repayment commitments as scheduled and would be in bad shape at the end of the period.

Also, practitioners believe:

• that below a net debt/EBITDA ratio of 2, the company should not have any repayment problems;
• that between 2 and 4, the situation deserves a more precise analysis depending on the company's sector of activity. For example, bankers are more willing to lend large amounts relative to EBITDA when cash flows are predictable and stable (infrastructure, agribusiness, telecom, real estate, etc.) than when flows are sensitive to the economy (technology, capital goods, oil services, etc.);
• that from 4 to 7, the company's debt is in all likelihood excessive, except in the case of LBOs, as we will see in Chapter 49. Debt then becomes a high-yield product, but also a high-risk one! These are the high yield loans. We are then in the leverage finance world;
• that beyond 7, even for an LBO, debt is excessive.

Naturally, these ratio levels should be taken for what they are: indications and not absolute references that change over time according to the lender's risk appetite. Moreover, the lender will be sensitive to the actual cash generation capacity: if past cash flow statements consistently show negative free cash flow after financial expenses, banks will find it very difficult to lend, even if EBITDA is comfortable.

Accordingly, when changes in working capital are not negligible compared with the amount of EBITDA, the net debt/EBITDA ratio loses its relevance.

The following table shows trends in the net debt/EBITDA ratio posted by various different sectors in Europe between 2005 and 2022e.

Source: Exane BNP Paribas

Telecom operators and utilities are among the most highly leveraged sectors. One explanation is their capital intensity, which is strong. Another is the willingness of lenders to lend money to these sectors given their high long-term visibility on cash flows (concession contracts).

Similarly, analysts look at the interest coverage ratio, ICR (or debt service coverage or debt service ratio), i.e. the ratio of EBIT to net interest expense. A ratio of 3:1 is considered the critical level. Below this level, there are serious doubts as to the company's ability to meet its obligations as scheduled, as was the case for the transport sector post 9/11. Above it, the company's lenders can sleep more easily at night!

Rating agencies generally prefer to consider the ratio cash flow to net debt (they call our cash flow “funds from operations”, or FFO). It is true that cash flow is closer than EBITDA to the actual capacity of the firm to repay its debt.

Not so long ago, the company's ability to repay its loans was evaluated on the basis of its debt-to-equity ratio, or gearing, with a 1:1 ratio considered the critical point.

Certain companies can support bank and other financial debt in excess of shareholders' equity, specifically companies that generate high operating cash flow. Getlink (Eurotunnel), the company which operates the Channel Tunnel and generates robust cash flows, is an example. Conversely, other companies would be unable to support debt equivalent to more than 30% of their equity, because their margins are very thin. For example, the operating profit of Balfour Beatty, the construction company, is at best only 1.5% of its sales revenue.

The debt-to-equity ratio is still computed by some analysts and used in some debt contracts in particular for SMEs. It is an unfortunate illustration of inertia of concepts in finance.

If you insist on using equity to compute debt ratios, it is better to use the ratio of net debt divided by the market value of equity. Equity is thus taken into account for what it is worth and not for a book amount, which is, most of the time, far from economic reality. Nevertheless, this ratio presents the drawback of being quite volatile due to the volatility in the equity's value.

2/ IS THE COMPANY RUNNING A LIQUIDITY RISK?

To understand the notion of liquidity, look at the company in the following manner: at a given point in time, the balance sheet shows the company's assets and commitments. This is what the company has done in the past. Without planning for liquidation, we nevertheless attempt to classify the assets and commitments based on how quickly they are transformed into cash. When will a particular commitment result in a cash disbursement? When will a particular asset translate into a cash receipt?

To meet its commitments, either the company has assets it can monetise or it must contract new loans or initiate a capital increase. Of course, just like capital increases, obtaining a new loan depends on the company and its specific situation, and is therefore uncertain.

Illiquidity comes about when the maturity of the assets is greater than that of the liabilities. Suppose you took out a loan, to be repaid in six months, to buy a machine with a useful life of three years. The useful life of the machine is out of step with the scheduled repayment of the loan and the interest expenses on it. Consequently, there is a risk of illiquidity, particularly if there is no market to resell the machine at a decent price and if the activity is not profitable. Similarly, at the current asset level, if you borrow three-month funds to finance inventories that turn over in more than three months, you are running the same risk.

An illiquid company is not necessarily required to declare bankruptcy, but it must find new resources to bridge the gap. In so doing, it forfeits some of its independence because it will be obliged to devote a portion of its new resources to past uses. In times of recession, it may have trouble doing so, and indeed be forced into bankruptcy.

We say that a balance sheet is liquid when, for each maturity, there are more assets being converted into cash (inventories sold, receivables paid, etc.) than there are liabilities coming due.

This graph shows, for each maturity, the cumulative amount of assets and liabilities coming due on or before that date.

If, for a given maturity, cumulative assets are less than cumulative liabilities, the company will be unable to meet its obligations unless it finds a new source of funds. The company shown in this graph is not in this situation.

What we are measuring is the company's maturity mismatch, similar to that of a financial institution that borrows short-term funds to finance long-term assets.

However, in real life, things are often more complex than the situation represented by the smoothed curves of the above graph. For example, the graph for a company with large debts maturing in five years would look like this:

The company will have to manage its debt (refinance) within a few years, or even restructure it (see Section 39.3).

Failure to comply with a covenant (see Section 39. 2) on a company's debt, by making it immediately due and payable, regardless of its residual maturity, considerably increases the company's liquidity risk. The accounting system immediately reflects this by downgrading medium- or long-term debts to short-term debts. The analyst must therefore not forget to take into account the proximity of the company to its covenants when assessing this risk.

3/ IS THE COMPANY EXPOSED TO A FOREIGN EXCHANGE RISK?

For example, going into debt in euros when all assets and cash flows are in dollars, allows you to benefit from lower euro interest rates, but also exposes you to a high exchange rate risk. Unless it is hedged (see Chapter 51), risk will become reality in the event of an appreciation of the euro. Some companies have disappeared as a result. It is therefore necessary to verify that this exchange risk has been properly assessed, or that hedges have been set up (swaps, options).